Pros and cons of bank loans for small businesses
Businesses in search of additional finance may consider taking out a bank loan. But what are the advantages and disadvantages of this funding source?
Start-ups and small businesses looking to expand often have at least one thing in common- they want some extra funding.
Although it would be ideal to fund their plans with their own money, the reality is that most small businesses simply do not have the spare capital themselves to invest in growth. As a result, they would normally need to turn to external sources. However, this then raises the question of which type of funding is most appropriate for your business and for your specific needs as there are many different options to consider.
Business loans are a common source of funding, but even within this category businesses will have a large range of choice. As well as the traditional high-street banks, you can also get both long-term loans and short-term loans from online-only lenders, with term periods ranging from one to 25 years.
Loans are available for a range of business purposes. For example, you can apply for funding for start-up costs, improvements to premises, purchasing new equipment, expanding the workforce, purchasing stock, and other operational activities.
To cater for this variety of needs, lenders, including banks, have developed specialist products such as asset financing, invoice financing, and working capital loans in addition to their standard business loans, to help businesses find the right kind of finance for their situation.
But how do you know if a business loan is the right step for your business to take? And if you decide that it is, how do you know which type of loan to take out? Before you start comparing business loans, it is helpful to find out more information on bank loans and some other lending providers.
This article will discuss in detail the advantages and disadvantages of bank loans for small businesses, to help you decide if they are the best business financing option or if alternative sources of funding are more appropriate.
What are the advantages of bank loans?
1. Allow you to grow your business
Bank loans are a convenient way to get extra finance, without needing to wait until your business has generated enough profit to fund expansion yourself. Taking out a loan means you can put your plans into action much earlier and take advantage of any business opportunities that present themselves, enabling faster and more accelerated growth.
Even though it can take weeks, or even months, to apply and get approval for a bank loan, this is still a practical way to raise funds to grow your business.
2. You keep full control of your company
The main advantage of a bank loan, as with any kind of small business loan, is the ability to get an injection to their cash flow without losing any control of your company. With some other funding options, like equity finance, you will be selling company stock to investors to get immediate funding which means you will have to share out the profits while you have the investor(s) on board. A small business loan is a more temporary measure, so once you pay off the loan you will have no more obligation to the lender.
One of the factors that sets a bank apart from other lending options is its familiar name and trusted reputation. Some small businesses may prefer to apply to a bank for a loan because of its long-standing name and the security they think this brings. The established high-street banks could appear a more reliable option in comparison to the newer, online-only lenders, but this view is perhaps growing less relevant as online lenders become a more popular and accepted source of funding.
4. No interference from the bank
One of the other advantages of a small business bank loan is that, as long as you make the repayments, banks shouldn’t interfere or set restrictions on what you use the loan for.
Of course, when you first apply for a bank loan, you will need to send in a business plan outlining how you plan to use the funds so the bank can assess the risk involved in lending to your business. However, once you have the funding, you have the flexibility to change your plans without any intervention from the bank, as long as you carry on repaying the loan.
5. Favourable interest rates
The interest rates on a small business bank loan can be more favourable than other online lenders. Especially if you are looking for a more long-term funding option, taking out a bank loan will normally work out much better value than using an overdraft, credit card, or a personal loan.
You will find banks a particularly cost-effective option if you have an existing business with a good credit score and a good financial history. The more established and successful your business, the less of a risk you will appear to banks, and so they are more likely to approve your application and offer you attractive interest rates. Taking out a secured loan will also help you to get lower interest rates.
Another perk of a bank loan for small businesses is that the interest you pay on the loan repayments is tax-deductible.
6. Banks may offer extra services
If you already have a relationship with a bank, if you have an account with them for example, they may be able to offer you lending advice based on their existing understanding of your business. Some banks may also provide you with a personal advisor to help answer any questions you have about the lending process. This personal relationship is something that online lenders in particular may not offer, and can be one of the advantages of taking out a small business loan with a bank.
However, this doesn’t mean that your existing bank, or indeed any bank, is the best lending option for your business.
What are the disadvantages of bank loans?
1. Strict eligibility criteria
One of the major disadvantages of a bank loan is that banks can be cautious about lending to small businesses. Their strict lending criteria can make it particularly difficult for start-ups and newer businesses to be accepted for a loan as they don’t have the financial or trading history to back up their application and, if they are accepted, the interest rates are likely to be increased to compensate for the added risk.
As a result, it’s more established businesses with a good credit history and good growth prospects that are likely to benefit the most from the advantages that a traditional bank loan can offer.
2. Lengthy application process
Preparing for a business loan application can also be a long and time-consuming process. Not only will you need to fill out an application form for each lender, but you will also need to provide a business plan, your account history, and your financial forecasts to show your business is a viable lending prospect. For more information on the application process, visit our Ultimate Business Loan Guide.
Traditional banks can take a long time to process this information and make a decision, especially if your business is applying for a large sum of money. Because of this, businesses wanting a quick injection of cash may struggle to get this from a high-street bank lender.
3. You may not receive the full loan amount
If your business loan is eventually approved by the bank, then there is a chance that you won’t receive the full amount that you applied for. A bank may decide your business doesn’t need that much money to carry out your project, or might deem it too risky to lend you the full sum. Because of this, businesses may want to prepare an alternative plan should they only receive a proportion of the requested funds.
4. Not suitable for ongoing expenses
One of the other disadvantages of a bank loan is that you can only use the funds for certain projects or purposes that will help grow your business, and not usually to cover any ongoing expenses. Banks will want to lend to businesses that will be able to repay the money, and so they will look for businesses that will use their money to invest, grow, and generate returns.
If a small business wants funding to cover a temporary cash flow problem or wants a short-term injection of cash, other financing options such as overdrafts, credit cards, or working capital loans may be more suitable.
5. Secured loans carry risk
Although taking out a secured business loan from a bank can be beneficial with its lower interest rates, businesses should remember that this puts their assets at risk should they fail to make the necessary repayments. Clearly, businesses will intend to make every payment, but it is still something you should bear in mind when applying for a loan. Despite this risk, by securing a loan against your business assets you should ensure your personal assets (such as your house) will remain unaffected if you default on the business loan.
There is an exception to this as, in some cases, banks may secure a loan against your personal assets if the business does not have any collateral to offer. Also known as a director, or personal, guarantee, this kind of business loan would require a personal asset (such as your house) to be used as collateral, which could put your home at risk if you miss your repayments for example.
Are there any other funding options?
If, having evaluated the advantages and disadvantages of bank loans, a small business still isn’t sure if this option is right for them, they may want to look at their other funding options.
Banks are not the only lenders available to small businesses. There is a growing number of online lenders that are becoming more popular and viable options for small businesses looking for funding. Because their overhead costs are typically lower than high-street banks, these online lenders may be more prepared to offer loans to businesses that are less established or have a less-than-perfect credit history, although this would typically be reflected in high interest rates.
You can also look beyond the traditional banks and online lenders for a business loan, as other lending channels are available to small businesses and start-ups. For example, the government-backed Start Up Loans Company can offer loans to businesses that have been trading for under 24 months.
Businesses may also want to look into specific types of loans, such as invoice financing and asset financing, to see if these options are more appropriate for their needs. There are other types of financing options that small business owners may want to consider too, such as peer-to-peer funding, crowdfunding, equity finance and business grants.
Grants are very competitive as they are non-repayable, but there are numerous national and regional small business grants available for many different projects and schemes.
Rhiannon is a financial writer for NerdWallet, with a particular interest in personal finance and insurance guides for consumers. Read more